Archive for October 2012

As much as I’ve been an unabashed critic of most of the financial media, I can’t help but noting that Money magazine’s October Retirement Guide issue has some excellent articles about preparing for retirement; and I recommend picking up a hard copy to pass around to family members. Articles in this issue discuss things most people simply don’t think about in advance.

Back in 2005, it became obvious that my parents back in Florida could no longer take care of themselves. Mom had broken a hip and was in a health center recovering from surgery – and the anesthesia didn’t help the Alzheimer’s which was then in its early stages. Meanwhile, dad, who was living alone while mom was in rehab, could barely get around. He had lung cancer, though he hadn’t told us about it and I’m not sure he even knew.

My wife and I made three trips between California and Florida over a six week period: Arranging financial and legal matters, home care for dad and mom when she arrived, selling their home, and prepping our home for their arrival, i.e., outfitting bedrooms, bathrooms, etc., and arranging for in-home care in our home for them when they arrived.

There was a lot we didn’t know and we had to learn on the fly. This issue of Money – look for the Retirement Guide sub-heading – is certainly worth reading and talking about with your family. It also asks some good questions like, “Who will change your light bulbs when you can’t? Do you trust them?” The answers may not be as easy as you think.

If you can’t wait to get a hard copy, you can read some of the articles here.

Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting and wealth management services for individual investors. Opinions expressed are solely those of the author and fictitious names were created solely for their entertainment value and are not meant to represent any person or organization living or dead. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com

When you sell an investment simply because it has declined in value, it becomes impossible to benefit when it rebounds. The same is true of the broad market in general. Many of these major upside moves can happen quickly, often in just a few days. To avoid missing these key days, you may want to consider staying invested and avoid panic selling. Consider this hypothetical example furnished to us by the folks at Principal Financial Group:

An individual who was invested in the S&P 500 from January 2, 1991, until December 31, 2010 would have turned a $10,000 investment into $58,137.02 for an average annual return of 9.20%, while an investor who panicked and sold their positions during this same period and missed the 10 best trading days in this period would have seen their return fall from 9.20% to 5.47%. [Source: Ned Davis Research]

The lesson is clear: No one can predict when the market will experience its best days.

2. Keep a Long-Term Focus

Studies show that time is your ally. Of the three types of investments studied (stock funds, bond funds, and asset allocation investment options), the average investors in asset allocation funds held their investment options the longest (an average of 4.30 years) over the five time periods studied (1-, 3-, 5-, 10-, and 20-years). It’s little surprise that these investors successfully weathered one of the most severe market declines in history (2000-2002). [Source: Dalbar 2010 QAIB study]

3. Have a Diversification Plan

According to the Dalbar study, investors guess incorrectly about the market’s direction 50% of the time. So, diversification helps guard against those errors; but, many people mistake duplication for diversification by buying multiple mutual funds not knowing many of the underlying holdings are identical.

Choosing different management styles and market capitalizations of equities and bonds isn’t as simple as you’re lead to believe on television. When was the last time you heard a financial entertainer the impact of highly correlated assets? It’s boring stuff and makes for poor television, which is why it isn’t discussed, but it’s what you need to know. Quality diversification enhances the benefits of asset allocation so investment balances are less affected by short-term market swings than they would be if you invested in a single asset class.

If you are an investor who is nearing retirement, consider consulting your advisor about this issue. Remember, asset allocation/diversification does not guarantee a profit or protect against a loss, but it will likely make your journey much smoother.

4. Utilize an Auto-Rebalance Strategy

Historically, business cycle contractions last about one-sixth as long as expansions. Now may be a good time to re-evaluate your risk tolerance. If you want a professionally managed investment option to handle this complicated task, you might want to consider a unified managed account (UMA). It’s an option that simplifies your paperwork, virtually automates the rebalancing process, gives you consolidated reporting while providing the diversification of management, styles, and investments needed to do the job right. UMAs can hold mutual funds, index funds, ETFs, institutional separately managed accounts, and more. A UMA is not an investment; it’s a type of account you use to execute your investment plan. Ask your advisor or – shameless plug – feel free to contact me for information about UMAs.

There are also target-date and target-risk asset allocation funds available on the market; but, tread carefully. Different funds with the same target date or target risk can still have very, very different holdings, styles, and risk profiles. Not everyone retiring in the same year has the same financial picture or ideas about how they want to make the financial journey. As you can tell, I’m not a big fan of ‘cookie-cutter’ solutions.

5. Keep Your Focus

Discipline is something everyone has until panic sets-in. Quite often, that’s when an advisor can show the most value. Successful investing is a marathon, not a sprint. The tortoise did win the race, you know.

6. Get Regular Checkups

Too many individual investors are still stuck in the old paradigm under which their advisor, actually a broker, would call them with investment ideas or changes they should make. Today, with the emergence of the fee-only – that’s different from fee-based – business model utilized by ‘pure’ Registered Investment Advisors (not dually registered to sell securities, too), the new paradigm operates more like other professional practices in law, medicine, or accounting. In short, you need to make an appointment for your checkup, at least annually. And, today, with online meeting technology, you can even do it without getting in your car… so there’s no excuse. Get your checkup! If you don’t, your financial health will likely suffer.

Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, Keep up to date with IFG on Twitter: @JimLorenzen

Bob Clark, in a recent AdvisorOne article, says the answer is “fear.” Many people are afraid of:

• Being embarrassed by their current financial condition

• learning their financial situation is much worse than they realized

• of getting beat up for not saving more

• of being told to do things they don’t want to do, such as going on a budget, saving more, or buying more insurance.

He’s probably right. The old adage WIIFM (What’s in it for me) maybe best answers what people really want: How to get their financial house in order and keep it that way forever; how to achieve their goals with peace of mind; how to minimize risk; how to feel good about what their future!

Jim

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Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights lettersfor individual investors. Keep up to date with IFG on Twitter: @JimLorenzen

It seems every election cycle brings with it the issue of who should bear the cost of government spending and to what degree. For many, the discussion begins with taking it from the rich and giving it to the poor. It’s as old as Robin Hood – probably older. And, since there are more poor people than rich, it plays usually plays well at the ballot box.

While most voters may not understand economics, they do know when they’re out of work; and they don’t like seeing their jobs going overseas.[i] Unfortunately, the U.S. tax code has become a ‘book of favors’ – a virtual ‘jobs protection act’ for elected officials primarily concerned with raising money for the next cycle and insuring votes for re-election.

How do tax cuts really work? IMHO the following little story[ii] – entirely made-up – provides a good example of how capital follows opportunity.

Here’s our scenario: Every day, ten men go out for dinner. The bill for all ten comes to $100 (I know, that couldn’t happen, but we’ll pretend). If they paid their bill the way we pay our taxes, it might look something like this[iii]:

The first four men (the poorest) would pay nothing.

The fifth would pay $1.

The sixth would pay $3.

The seventh $7.

The eighth $12.

The ninth $18.

The tenth man (the richest) would pay $59.

So, the ten men ate dinner in the same restaurant every day and seemed quite happy with the arrangement, until one day the owner threw them a curve.

“Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily meal by $20.”

Now the dinner for all ten cost only $80. The group still wanted to pay their bill the way we pay our taxes.
So, the first four men were unaffected. They would still eat for free. But what about the other six, the paying customers? How could they divvy up the $20 windfall so that everyone would get his ‘fair share’?

The six men realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being ‘PAID’ to eat their meal!

So, the restaurant owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay[iv].

Here’s how it turned out:

The fifth man, like the first four, now paid nothing (100% savings).

The sixth now paid $2 instead of $3 (33% savings).

The seventh now paid $5 instead of $7 (28% savings).

The eighth now paid $9 instead of $12 (25% savings).

The ninth now paid $14 instead of $18 (22% savings).

The tenth now paid $49 instead of $59 (16% savings).

Seems fair enough. Each of the six was better off than before. And the first four continued to eat for free. But once outside the restaurant, the men began to compare their savings.

“Hey! I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man “but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than me!”

“That’s true!!” shouted the seventh man. “Why should he get $10 back when I got only $2?” He became upset at the injustice. “The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get anything at all. The system exploits the poor!”

The nine men surrounded the tenth and beat him up. Apparently, tax breaks for the wealthy aren’t popular.
You can probably guess what happened after that. The next night the tenth man didn’t show up! So, the nine sat down and ate dinner without him.

Alas, when it came time to pay the bill, they discovered something important: They didn’t have enough money between all of them for evenhalf of the bill! Oops.

It’s a simple lesson many journalists and college Keynesian-schooled professors have problems grasping, yet this is how our tax system actually works! Tax laws have historically been used to direct the flow of capital. And, the ones who get the most money back from a reduction are – or should be – those who paid-in the most to begin with.

Here’s the lesson of our dinner group story:

Increasing taxes on those we feel have too much capital, simply because they have wealth, destroys their incentive. As in our story, they just may not show up “at the table” anymore. They will remind us all there are lots of good restaurants in China, India, South Korea, Europe and the Caribbean. They know – and we should too – jobs are created where capital is directed. If we provide incentives to direct capital someplace else, we will simply be draining capital from the economy and the rest of us will be stuck with a bigger bill.

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an ACCREDITED INVESTMENT ADVISOR® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights lettersfor individual investors. Keep up to date with IFG on Twitter: @JimLorenzen

[i] Recommended reading: The World Is Flat, by Thomas Friedman, a volume on the economic impact of globalization – the leveling of the playing field – and America’s new place in this paradigm. Should be required reading for anyone interested in this issue.

[ii] Not original and I don’t know the author. It was relayed to me by a colleague about six years ago.

[iii] This is a hypothetical example of a progressive tax system and its impact on a population of taxpayers.

[iv] The restaurant owner figured, as an example, that if the eighth man was paying 12% of the tax before, he should be entitled to 12% of the savings. 12% of the $20 savings is $2.40. Since he decided it should be ‘roughly’ the same and to make it easier on the diners to figure the bill, he rounded-up (in this case) and decided man #8 should get $3 of the savings.

Given the increasing deficits, the outlook for growth is problematic. It would appear there are three available options. Which one do you think the politicians will choose?

(1) Reduce the level of debt, i.e., reduce spending; or

(2) A combination of higher taxes and reduced spending; or

(3) inflation.

Since politicians can’t seem to get agreement on either of the first two, don’t be surprised if inflation will be the “solution” – the one that will bear no one’s finger prints and allow everyone to blame the other in their next re-election campaign… it’s always good to have another issue in your back pocket, you know.

Inflation is a common solution. One study has found that in the past 400 years, inflation has been the most common way that governments have dealt with excessively high levels of debt.[1] The reasons stated above help explain why.

Those of you who’ve been following my pontifications over recent years may remember my going on about this issue before.

The short version: Look for the U.S. to simply print money and inflate the currency to repay the debt – and taxpayers will be left paying for their spending to buy re-election.

While the Main Stage debate will be over tax brackets and deductions, who pays, etc., the real action will be off to the side out of sight: Hidden taxes through higher prices, taxes buried inside the higher prices, fees we don’t know we’re being charged.

My guess: Expect average growth and above average inflation as countries around the globe attempt to deleverage by engaging in competitive devaluation to rebuild their economies. The U.S. may be attempting to win that race. This could be a five-year window – maybe more; I doubt it will be less.

Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights letters for corporate plan sponsors and individual investors. Keep up to date with IFG on Twitter: @JimLorenzen

What are scattered assets? Many people have multiple investment accounts, often with multiple brokerages and or mutual fund companies. There are even those who have multiple institutional managers in separately managed accounts.

And, all this is in the name of diversification. I just wrote about this in our ezine which you can find on the IFG Insights Archive. But, here’s an overview:

Problem is, most of these people aren’t diversified at all? In fact, rather than reducing risk, they may actually be increasing it!

There are three issues at play – issues many often ignore:

Duplication is not diversification. But, there’s more: Few people realize that you can’t really diversify-away market risk. Think about it: If you bought stocks in the ENTIRE stock market, you’d only be replicating market risk, not eliminating it.

Mutual funds contain hidden taxes. Sure, most people know that; but, what they may not know is this: They don’t own the underlying fund holdings; they are shareholders of the investment company and as such they share in the fund’s capital gains. If the fund sold a stock they bought ages ago at a low price and now has large unrealized gains; the shareholder will share in ALL of those gains, even if the stock is sold just after the investor bought-in!

Tax inefficiency. This happens when there are multiple managers, even if one of them is the client, in addition, buying securities in his own online account. The duplication mentioned above can result in some real costs that can far outweigh any perceived savings. Again, you’ll find a detailed example in this morning’s IFG Insights, which you can find in our archive.

Like Warren Buffet once said, if you think investing is fun, the odds are great you’re doing something very wrong.

Enjoy!

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Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, and by subscribing to IFG Insights letters for individual investors. Keep up to date with IFG on Twitter: @JimLorenzen

Getting ready to retire? Wondering whether you should sell or roll-over your company stock? That’s really a tax-treatment question, which means you should consult with your tax professional; but, here’s a little information you may want to review

What you should know: Shares of employer stock get special tax treatment, and in many cases, it may be fine to ignore this special status and roll the shares to an IRA. This would be true when the amount of employer stock is small, or the basis of the shares is high relative to the current market value.

However, if you have large amounts of shares or low basis, it might be a very costly mistake not to use the Net Unrealized Appreciation (NUA) Rules.[1]

If your company retirement account includes highly appreciated company stock, one option is to withdraw the stock, pay tax on it now, and roll the balance of the plan assets to an IRA. This way you will pay no current tax on the Net Unrealized Appreciation (NUA), or on the amount rolled over to the IRA. The only tax you pay now would be on the cost of the stock (the basis) when acquired by the plan.

By the way, if you withdraw the stock and are under 55 years old, you have to pay a 10% penalty (the penalty is applied only to the amount that is taxable).

So, you can then defer the tax on the NUA until you sell the stock. When you do sell, you will only pay tax at the current capital gains rate, whatever it is at that time. To qualify for the tax deferral on NUA, the distribution must be a lump-sum distribution, meaning that all of the employer’s stock in your plan account must be distributed.

Hypothetical Example:

Jackie just retired and has company stock in her profit sharing plan. The cost of the stock was $200,000 when acquired in her account, and is now worth $1 million.

The Rollover Option: If she were to rollover the $1 million to her IRA, the money would grow tax-deferred until she took distributions. At that time, the withdrawals would be taxed as ordinary income – for this hypothetical, let’s assume 35% federal. When Jackie dies, her beneficiaries would pay ordinary income tax on all of the money they receive.

Withdrawing the Stock: But if Jackie withdrew the stock from the plan rather than rolling it into her IRA, her tax situation would be different. She would have to pay ordinary income tax on the $200,000 basis. However, the $800,000 would not be currently taxable. And she would not have to worry about required minimum distributions on the shares. If she eventually sells the stock, she would pay the lower capital gains tax on the NUA and any additional appreciation.

Jackie’s beneficiaries would not receive a step-up-in-basis for the NUA. However, they would only pay at the capital gains rate. Appreciation between the distribution date and the date of death would receive a step-up-in-basis (we’ll assume a 15% capital gains rate); therefore would pass income tax-free.

With NUA

Without NUA

35% Tax on $200,000

$70,000

35% Tax on $1 million

$350,000

15% Tax on $800,000

$120,000

Total Tax

$190,000

$350,000

Let’s assume the stock value increases to $1.5 million in five years, and she decides to sell.

With NUA

Without NUA

Taxable Amount

$1.3 million

$1.5 million

Tax Rate

15%

35%

Potential Income Tax to Jackie

$195,000

Plus Amount Previously Paid

$70,000

Total Tax

$265,000

$525,000

Finally, assume that Jackie died in five years after the stock increased to $1.5 million. What would her beneficiaries have to pay?

With NUA

Without NUA

Taxable Amount

$800,000

$1.5 million

Tax Rate

15%

35%

Income Tax

$120,000

$525,000

Amount Receiving Step-Up in Basis

$500,000*

0

*Because 2010 is a transition year with estate taxes, there is a limit on the step up in basis of $1.3 million for capital gains.

Okay, now you know enough to be dangerous. Next step: Meet with your tax professional to (1) check for any possible tax law changes, and (2) plug-in your own numbers and tax rates, and (3) discuss any complicating issues this piece isn’t considering.

I have a report, entitled “Six Best and Worst Rollover Decisions” available and there’s a link to it in our ezine that covers this topic. You’ll find it in our Insights archive. You might want to subscribe.

Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights letters for corporate plan sponsors and individual investors. Keep up to date with IFG on Twitter: @JimLorenzen